Open-Economy Macroeconomics

Macroeconomic Theory of the Open-Economy

• This model aims to identify which forces determine both trade balance and exchange rates.
• It examines the market for loanable funds & the market for foreign currency exchange simultaneously.
• Real GDP (Y) is given and determined by the supply of factors and level of technology
• The price level is given and determined by money demand and supply.

Market for Loanable Funds

• All savers and borrowers interact in this market in an open economy.
• S = I + NX which is also S = I + NCO
• Saving equals domestic investment plus net capital outflow.
• Loanable funds can be interpreted as the flow of resources generated domestically for capital accumulation.
• Purchasing capital assets adds to demand for loanable funds.
• The supply of loanable funds comes from national saving (S).
• The demand for loanable funds comes from domestic investment (I) and net capital outflow (NCO).

Net Capital Outflow Scenarios

• When NCO > 0, there is a net outflow of capital and net purchase of capital overseas. This adds to the demand for domestically generated loanable funds.
• When NCO < 0, there is a net inflow of capital and capital resources come from abroad, which reduces the demand for domestically generated loanable funds.

Interest Rates

• Assets located at home are represented by "I" and assets located abroad are represented by "NCO"
• A higher real interest rate encourages saving, increasing the quantity of loanable funds supplied.
• Higher interest rates discourage investment, decreasing the quantity of loanable funds demanded.
• Higher interest rates discourage residents from buying foreign assets, reducing net capital outflow.
• Higher interest rates encourage foreigners to buy assets, reducing net capital outflow.

Equilibrium Interest Rate

• The interest rate in an open economy is determined by the supply and demand for loanable funds.
• The supply of loanable funds slopes upward and encourages people to save.
• The demand for loanable funds slopes downward.
• At equilibrium, the amount people want to save exactly balances the desired quantities of domestic investment and net capital outflow.

Foreign-Currency Exchange

• NCO = NX
• Net capital outflow equals net exports.
• In a trade surplus (NX > 0), exports are greater than imports, creating a net sale of goods and services abroad. Domestic citizens use the foreign currency to buy foreign assets, and capital flows abroad, NCO > 0.
• In a trade deficit (NX < 0), imports are greater than exports, needing financing by selling domestic assets abroad. Foreign capital flows into the home country, NCO < 0.

Foreign Exchange Market

• The supply of foreign-currency exchange comes from net capital outflow.
• The quantity of dollars supplied is used to buy foreign assets and the supply curve is vertical.
• The quantity of dollars supplied for net capital outflow is independent of the real exchange rate.
• The demand for foreign-currency exchange comes from net exports and the quantity of dollars demanded to buy U.S. net exports.
• The demand curve slopes downward, and a higher real exchange rate makes U.S. goods more expensive, causing exports to fall and imports to rise.
• A higher real exchange rate reduces the quantity of dollars demanded to buy those goods and services.

Real Exchange Rate

• Investment decisions are based on the expected return and so the impact of real exchange rate on return is negligible
• Thus the real exchange rate shouldn't impact NCO.
• The real exchange rate is determined by supply and demand for foreign-currency exchange.
• The supply of dollars comes from net capital outflow and is vertical because net capital outflow does not depend on the real exchange rate.
• Demand for dollars comes from net exports, sloping downward as a lower real exchange rate stimulates net exports.
• At equilibrium, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports.

Currency

• NCO generates the supply of domestic currency & NX generates demand for domestic currency.
• If NCO rises (falls), the domestic currency depreciates (appreciates).
• NCO generates the demand for foreign currency (to buy foreign assets) & NX generates the supply for foreign currency (to buy goods and services produced in home country).
• If NCO rises, foreign currency appreciates and domestic currency depreciates.

Open Economy Equilibrium

• Market for loanable funds: S = I + NCO
• Market for foreign-currency exchange: NCO = NX
• Links are between the markets for loanable funds & foreign-currency exchange
• Equilibrium in the open economy is defined by the interplay of equilibrium real interest rate and real exchange rate, national saving, net capital outflow, and domestic investment.

Equilibrium Adjustments

• Equilibrium real interest rate balances the price of goods and services in the present relative to the future.
• Equilibrium real exchange rate balances the price of domestic goods relative to foreign goods and services.
• The exchange rate and the interest rate adjust simultaneously to balance supply and demand in both the loanable funds and foreign-currency exchange markets.
• They determine national saving, domestic investment, net capital outflow, and net exports

Government Budget Deficits

• Government budget deficits occur when government spending exceeds government revenue, resulting in negative public saving and reduced national saving.
• This leads to a reduced supply of loanable funds, an increased interest rate, and reduced net capital outflow.
• Subsequently crowding out domestic investment and decreasing its supply in foreign-currency exchange, and causing the currency to appreciate.
• Which causes net exports to fall, pushing the trade balance toward deficit.
• The government budget deficit leads to a lower balance of trade according to the equation S = I + NX.
• If trade deficits are caused by budget deficits, they are called "twin deficits."
• Other factors can cause trade deficits as well.

Trade Policy

• Trade policy, a government policy, directly influences the quantity of goods and services a country imports or exports.
• Policies include tariffs on imports, import quotas (limits on quantity), and voluntary export restrictions.
• Trade policies do not affect the trade balance overall.
• Trade policies do affect specific firms, industries, and countries.
• They have a macroeconomic impact by decreasing imports, increasing net exports, and increasing demand for dollars in the market for foreign-currency exchange.

Import Quotas

• Import quotas lead to real exchange rate appreciation, discourage exports and do not change real interest rates or net capital outflow.
• There is no change in net exports (NX = NCO = S – I), which leads to a decrease in both imports and exports
• The resulting trade policies do not affect the trade balance, only affecting specific firms and industries.

Political Instability and Capital Flight

• Political instability leads to capital flight.
• Capital flight is a large and sudden reduction in demand for assets located in a country.
• Capital flight from Mexico in 1994 due to political instability caused investors to sell Mexican assets and buy U.S. assets, considered a "safe haven."
• Capital flight affects both the loanable funds and foreign-currency exchange markets.

Mexico Capital Flight

• Mexico's net capital outflow increases.
• The supply of pesos in the market for foreign-currency exchange increases.
• The demand curve in the market for loanable funds increases, leading to an increase in the rate in Mexico.
• Domestic investment slows along with capital accumulations, ultimately slowing economic growth in Mexico.
• Mexican Peso depreciates making exports cheaper and imports more expensive, resulting in the shift of the trade balance.

Impact on the U.S. Market

• In the U.S. market, there is a fall in U.S. net capital outflow, dollar appreciates in value, and U.S. interest rates fall.
• There is a relatively small impact on the U.S. economy because the economy of the United States is large in comparison to Mexico's economy.

China vs USA

• Chinese government accumulates foreign assets, including US government bonds
• NCO increases and subsequently the value of the Chinese currency depreciates
• The EX of China receives help and this increases the level of employment
• US NCO decreases, the US trade balance worsens and the money appreciates
• US interest rates decrease
• China sacrifices its own consumption and domestic investment but generates jobs
• US domestic investment improves at the deficit of trade. US citizens get access to cheaper chinese goods.